The Federal Reserve's Utter Policy Failure

By Megan McArdle

PIMCO CEO Mohamed A. El-Erian gave a speech
at the St Louis Fed in which he argued that the Federal Reserve and the ECB were
trying to solve the world's problems alone, but they can't and need help from
others.

What I take as his key points:

While central banks can -- and have -- stabilized things, there is little they
can do on their own to engineer the fundamental realignments that must
accommodate seven specific dynamics in advanced economies (something that we
will come back to later in discussing the way forward):

Accommodating the "safe" debt de-leveraging of the private sector by
enabling high sustained growth

Adjusting to the ongoing developmental breakout phase in several
systemically important emerging countries (including Brazil, China, India, and
Indonesia).

To be effective, central banks in advanced economies needed -- and need -- help
from other policymaking entities to deal with the twin unfortunate realities of
too much debt and too little growth. They must be assisted with the engagement
of the healthy balance sheets around the world, and fortunately there are quite
a few of them in both the public and private sectors. And this must be done in
an internationally coordinated fashion in order to accommodate the new global
realities.

El-Erian is attempting to tease apart what monetary policy can and cannot do,
yet paradoxically he falls prey to the commonplace conflation of macroeconomic
and microeconomic goals.

Put simply, the goal of macro policy is to balance maximum employment against
stable prices. This, however, is easily confused with goals relating to growth,
prosperity and health of public and private balance sheets.

Because, population and productivity have grown consistently in the
capitalist world for the last 300 years or so, the only time that we have
experienced strongly negative economic growth -- general declines in prosperity
and widespread deterioration in balance sheets -- is during recessions and wars.

Central Banks don't have direct control of wars but they do control
recessions. Thus its natural to think that the goal of central banking is to
produce growth, prosperity and financial health.

However, on a basic level its not. If the economy is running at maximum
employment and the prices are moving in a steady and predictable fashion then
the central bank has done its job. What happens to growth is ultimately not the
Fed's concern.

Consequently, when folks like myself point out the ongoing abject policy
failure of the Federal Reserve and the absolute nightmare that is the ECB, our
complaint is not about growth, it is about employment.

Let me be more concrete.

The American public education system is by many accounts a train wreck. We
consistently fail to motivate and educate the poorest third of our children.
Poignantly, we even seem to be failing poor children who score highly on
aptitude tests when they are very young.

Without developing skills in math and science it is highly unlikely that
these children will be able to reach their potential as contributors to the
American economy and consequently they are likely to earn very low wages and be
poor as adults.

This is a deep problem.

However, it is not a problem that suggests the United States will face high
unemployment or unstable prices. A macro-economically healthy economy will
create low wage jobs for our low skilled workers. Overall GDP will be lower.
More or our citizens will live in poverty. The pace of human knowledge expansion
will slow. However, the macro-economy will be steady and the Fed will have done
its job.

What tells us that the Fed is failing is that there are not enough low wage
jobs to employ all of our low skilled workers. Moreover, this is happening at
exactly the same time that price growth is slower than its long run trend.

The challenge of Central Banking is the goals high balance job creation and
low inflation. When job creation is slow and inflation is lower than our long
run goals the Central Bank is failing.

This is not the fault of fiscal policy. This is not the fault of
microeconomic problems like poor education or a crumbling infrastructure. This
is not the fault of a private sector that is unwilling to do its part.

This is the fault of a Federal Reserve hamstrung by a gutless unwillingness
to do its job. Though I would rate the performance of the ECB as vastly worse,
at least it has the excuse that it is only official task is holding inflation
steady. This, like the Eurozone itself, was a dreadful policy decision, but it is
the world we live in.

The Federal Reserve on the other hand has a dual mandate which it is
consistently and flagrantly ignoring. Offering sympathetic sounding bromides
about the need for policy makers to work together may make Federal Reserve
officials feel better about themselves but it disguises the deeper truth that
the failure of the US economy to reach full employment is their failure.

The erosion of skills, the decline in capital formation and the destruction
of lives that stem from high unemployment is the doing of one policy
institution.

The Federal Reserve knows exactly what it needs to do to remedy this situation:
commit to zero interest rates until nominal spending in the US economy is within
2% of its 1990- 2007 trend line.

That the Federal Reserve refuses to do this is a choice that it alone must
answer for.